A Radical Proposal To Change The Stock Market Could Completely Kill High-Frequency Trading

Monday

Mar 31, 2014 at 12:01 AMMar 31, 2014 at 9:11 AM

Linette Lopez

With his new book, Michael Lewis is trying to completely change the conversation about high frequency trading on Wall Street. Up until now it's been about whether or not high speed firms even have an advantage that distorts the market and hurts other investors.

After enough people have read 'Flash Boys: A Wall Street Revolt', however, it may evolve into an argument about what we should do about it.

There are already some suggestions out there. One comes from a group of professors who've come up with a radical new way to trade stocks called "frequent batch auctions."

Here's how it would work. Instead of trading consistently, the stock market would trade batches of orders in intervals of a second, or a tenth of a second — whatever is decided.

Professors Eric Budish, Peter Cramton, and John Shim laid it out in a paper titled "The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response" [PDF] which they presented in December.

Traders would not be able to see the prices at each auction; rather, the exchanges would collect the orders at the time of auction and execute them where bids match offers, thus consistently finding the right price without manipulation, according to the professors.

Sunday on 60 Minutes, Lewis and the subjects of his book — two founders of a private exchange called IEX — discussed two issues with HFT that frequent batch auctions could solve, front running and collocation.

Front running is exactly what it sounds like, and you can think of it like this: You're waiting in line to buy a carton of milk that's $2. By the time you get to the front of the line though, a high frequency shopper has bought a bunch of milk and driven up the price. Now the milk is $2.25.

Oh, and the guy who got in front of you, took the milk you had in your hand, bought it, and then sold it back to you. So he's making that $0.25.

Frequent batch auctions, in theory, would force exchanges to look at everyone's trades at the same time. That means no one could bump ahead of you in line.

Exchanges won't like this because they get paid on the volume of orders sent through their systems, regardless of whether or not the orders are filled. When someone jumps in front of you and grabs your milk, it's really a pointless order for the market, but it works out for the exchanges' bottom line.

Collocation — when high frequency trading firms have an advantage because they're simply closer to exchanges — would cease to be advantageous as well.

Earlier this month, New York Attorney General Eric Schneiderman said he was going after HFT market manipulation, and came out in favor of frequent batch auctions.

However, that doesn't mean that all anti-HFT people are on board. Themis Trading's Sal Arnuk, an advocate of slowing down the speed of trading on stock exchanges, told Business Insider that it may not be necessary to go that far.

"I think that many tools are in place that, if regulated properly, allow all players to coexist peacefully. HFT plumbing arbitrage would arbitrage itself into extinction without payment for order flow like maker taker and retail order buying," he said.

Then there's the question of whether or not a change like this would make already complicated exchange software even more complex.

Lev Lesokhin, of software risk analysis firm CAST, told Business Insider that putting the brakes on the "unconstrained" race for speed is long overdue but that rewriting exchange systems to deal with auctions could do just that.

Above all this, there's also the possibility that high frequency trading firms will just find a way around auctions.

"I think there's going to be ways to get around that speed limit," Lesokhin said. "And it's going to make systems more complex. This is problem with regulation. Once you think about how it's really going to get deployed, it's not as clear as regulators would like."

You know what the road to hell is paved with.

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